Rates Spark: Omicron inversion - ING Think

Economic and Financial Analysis

                                                                                                                     Rates

1 December 2021
                  Rates Spark: Omicron inversion
Article

                  The Omicron variant and the winter wave underway in many countries do not
                  subtract from inflation worries – they add to them. Flatter curves are the
                  logical consequence, and some real rates are moving higher too. The US front
                  end continues to trade with a decent rate hike discount. Makes sense to us,
                  especially as hikes are not expected till 2H 2022

                     Content
                     - The US front end tells a story – hikes are still coming
                     - Near-term risks to affect mostly long-end rates
                     - While inflation fears keep front-end rates up
                     - Today’s events and market views

                  The US front end tells a story – hikes are still coming
                  The likely outcome for market rates in the coming days will likely be a digital reaction to what
                  science has to say on Omicron. Good and bad news has been reacted to so far, with the move
                  lower in yields and acknowledgement that circumstances have in net terms veered towards the
                  worst. But we await a clearer vision on this. We have not, as yet, had confirmation that a follow-
                  through lurch lower in market rates is required, but what we can say is any material break
                  below 1.4% (there is a key technical point at 1.385%) on the US 10yr could quickly take us back
                  to the 1.3% area that we plateaued at through much of the summer. That would be quite a

setback for higher end-year yield aspirations.

Despite Omicron, USD OIS are pricing just over 2 hikes next year

Source: Refinitiv, ING

    Gearing for Fed hikes still makes considerable sense

At the same time, the US front end is not taking out any of the rate hike discount. The 2yr
remains in the 50-60bp area. Gearing for hikes still makes considerable sense. Remember the
hikes are not expected to happen till the second half of 2022. By then, this latest Covid scare
should be behind us. We don't have enough to suggest that that should change, and in fact
Chair Powell has intimated that a closer scrutiny of inflation risks is warranted. Indeed, the
inflation story, while often ignored by the fixed income market in the past number of months,
has a persistence about it. If it won't go away, and it looks like it won't (at least not easily) then
market rates will have to be ultimately tempted higher.

Near-term risks to affect mostly long-end rates
A winter Covid-19 wave is unwelcome news, and the wave of restrictions associated with them
pose a threat to a near-term growth outlook that wasn’t brilliant to begin with in Europe. Travel
restrictions imposed since the discovery of the Omicron variant add to these concerns, even if
they might be reversed within a few weeks, or months. The bias towards pricing negative news
was evident once again on Tuesday and we expect markets, through the volatility, to continue
trading with a downbeat tone into year-end.

Curve flattening makes sense both on inflation and Covid-19 risk

Source: Refinitiv, ING

    We expect markets to continue trading with a downbeat tone into
    year-end

In this context, the outperformance of long-dated rates makes sense, although they were
probably lent a helping hand so far this week by month-end extension flows. More to the point,
we would normally expect curves to bull-flatten on adverse developments. One could question
if this applies at the onset of a tightening cycle where front-end rates could in theory price a
more dovish path for policy rates on further Covid19-related worries . We think not.

While inflation fears keep front-end rates up
We are inclined to think of the near-term Covid risks to the outlook as factors that are transitory
in nature, and that do not necessarily subtract from medium-term inflation fears. The surge in
inflation on the other hand can no longer be described as transitory. Fed Chair Powell speaking
in favour of faster tapering and yet another upside surprise in Eurozone inflation were clear
reminders of that. In other words, it is entirely possible for both Covid-19 and inflation fears to
be priced simultaneously by the market. This is most likely to occur via a flattening of the yield
curve.

USD and EUR real rates have rebounded on the Omicron scare

Source: Refinitiv, ING

    Unconditional monetary support can no longer be counted on

Another take-away is that despite very real near-term worries for the outlook, central banks are
taking steps to prepare markets for less monetary support going forward. Powell warning of a
faster taper yesterday was the most conspicuous example, but we have documented in
previous publications that the ECB is more than aware of upside risks to its inflation forecasts. It
took more adverse Covid-19-related news for real rates to notice, tentatively so far, but this is a
clear sign that unconditional monetary support can no longer be counted on.

       Today’s events and market views
       November PMIs will spice up an otherwise quiet European morning. Only the Spanish
       and Italian readings are first releases but the acceleration of the fourth Covid-19 wave
       in November, and worries related to the new Omicron variant to a lesser extent,
       increase the chance of downward revisions to preliminary readings.
       Germany will auciton 5Y debt.
       BoE governor Bailey is scheduled to make a public appearance on the topic of insurance
       regulation. The event doesn't necessarily lend itself to comments on monetary policy
       but, with the fate of the December hike on a knife's edge, we will listen in nonetheless.
       If this fails to excite markets, ADP employment and ISM manufacturing should,
       alongside another testimony before Congress by Fed Chair Powell, where he is sure to
       be asked about inflation. While Powell likely has delivered the message he intended on
       tapering already (see above), he could take this opportunity to reinforce the message.

Padhraic Garvey, CFA
Regional Head of Research, Americas
1 646 424 7837
padhraic.garvey@ing.com

Benjamin Schroeder
Senior Rates Strategist
+31 20 563 8955
benjamin.schroder@ing.com

Antoine Bouvet
Senior Rates Strategist
+44 20 7767 6279
antoine.bouvet@ing.com

Disclaimer

This publication has been prepared by the Economic and Financial Analysis Division of ING Bank N.V. ("ING") solely for information purposes
without regard to any particular user's investment objectives, financial situation, or means. ING forms part of ING Group (being for this purpose
ING Group NV and its subsidiary and affiliated companies). The information in the publication is not an investment recommendation and it is
not investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Reasonable care has been taken to
ensure that this publication is not untrue or misleading when published, but ING does not represent that it is accurate or complete. ING does
not accept any liability for any direct, indirect or consequential loss arising from any use of this publication. Unless otherwise stated, any
views, forecasts, or estimates are solely those of the author(s), as of the date of the publication and are subject to change without notice.
The distribution of this publication may be restricted by law or regulation in different jurisdictions and persons into whose possession this
publication comes should inform themselves about, and observe, such restrictions. Copyright and database rights protection exists in this
report and it may not be reproduced, distributed or published by any person for any purpose without the prior express consent of ING. All
rights are reserved. ING Bank N.V. is authorised by the Dutch Central Bank and supervised by the European Central Bank (ECB), the Dutch
Central Bank (DNB) and the Dutch Authority for the Financial Markets (AFM). ING Bank N.V. is incorporated in the Netherlands (Trade Register
no. 33031431 Amsterdam). In the United Kingdom this information is approved and/or communicated by ING Bank N.V., London Branch. ING
Bank N.V., London Branch is deemed authorised by the Prudential Regulation Authority and is subject to regulation by the Financial Conduct
Authority and limited regulation by the Prudential Regulation Authority. The nature and extent of consumer protections may differ from
those for firms based in the UK. Details of the Temporary Permissions Regime, which allows EEA-based firms to operate in the UK for a limited
period while seeking full authorisation, are available on the Financial Conduct Authority’s website. ING Bank N.V., London branch is registered
in England (Registration number BR000341) at 8-10 Moorgate, London EC2 6DA. For US Investors: Any person wishing to discuss this report or
effect transactions in any security discussed herein should contact ING Financial Markets LLC, which is a member of the NYSE, FINRA and SIPC
and part of ING, and which has accepted responsibility for the distribution of this report in the United States under applicable requirements.